June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 72 of 92 liquidity is a complex but necessary effort in measuring liquidity adequacy. The Framework for determining CFaR is comprised of the same elements that made up the Framework for assessing Equity-at-Risk outlined in the previous chapters. In this instance one is evaluating the sources and uses of cash as opposed to the the effect of earnings on the equity situation. The following will explore this concept in greater detail. 8.2. Elements of the Framework As with Earnings, it is helpful to view one’s Cash Flow as a portfolio of components whose value changes with changes in the Market Risk Factors. CFaR is defined as the maximum shortfall of net cash generated, relative to expected cash from operations, because of the impact of market risks on a specified set of exposures, for a specified reporting period and confidence level. Since the framework can be fundamentally similar to analyzing earnings, it is important to understand the differences in earnings components and cash flow components before discussing the elements of the framework. Table 8.1 outlines those differences. Table 8.1 Earnings and Cash Flow Components Financial Component Earnings Cash Flow Procurement and Utilization of Inventory Inventory accounting methods such as LIFO and FIFO will affect when expenses for inventory are recognized. Cash Flow must immediately recognize any cash outlay for inventory procurement when it happens. Non Cash Charges: Depreciation / Amortization Must be recognized in Earnings Does not affect Cash Flow Non Cash Earnings: MTM Gains (Losses) Must be recognized in Earnings Does not directly affect Cash Flow however, MTM changes can result in Margin calls which will affect cash flow. Credit Collateral / Margining Will not directly affect earnings however it can result in preventing capital from being deployed to create Earnings. Will directly affect Cash Flow Accounts Receivable / Accounts Payable Will be included in Earnings Must be backed out for Cash Flow Matching of Revenues and Expenses Accounting rules allow matching in most cases, which will affect the timing of recognizing expenses. Cash outlays must be immediately recognized in Cash Flow With the establishment of what CFaR is and clarifying the differences between Earnings and Cash Flow, the following are the elements of a CFaR determination